Much Ado About Nothing?

Much Ado about Nothing?

In July 2012, four scholars issued a report—Does the Revolving Door Affect the SEC’s Enforcement Outcomes?—suggesting that concerns about the SEC’s revolving door are unfounded, at least with respect to the agency’s efforts to enforce the law.

The widely noted study by academics at four business schools looked at the outcomes in certain enforcement cases and reached a stark conclusion: “Our evidence…alleviates widely expressed concerns about the detrimental effect of revolving doors.”

However, a close look at the study leads to the conclusion that it hardly settles the issue.

The authors were rebutting sentiments like those articulated by Senator Grassley, ranking member of the Judiciary Committee, who remarked in 2011 that the “revolving door between [SEC] staff and the investment firms and banks they oversee has led to concerns of coziness and the soft-pedaling of potential criminal cases.”

“Rocking the boat is just not…an optimal way to segue into a major white-shoe law firm role.”

Others, including academics, whistleblowers, and the SEC’s Inspector General, have suggested that the constant movement of employees between the SEC and powerhouse firms has biased the agency’s enforcement efforts.

The “revolving door problem” may help explain why the SEC has gone after “individuals in small-bore cases,” but has not brought many charges against the “people in the financial crisis of 2008 who went over the line and should have been held accountable,” a former federal prosecutor told POGO.

As the former prosecutor explained it, taking aggressive action against companies represented by powerhouse law firms can hurt the future job prospects of SEC attorneys: “Rocking the boat is just not…an optimal way to segue into a major white-shoe law firm role.”

But the authors of the July 2012 study came to a very different conclusion: if anything, they said, the revolving door has actually strengthened the SEC’s enforcement efforts.

Quantifying the Effects of the Revolving Door

The authors described two ways in which the revolving door could bias the SEC. On one hand, agency lawyers might “follow aggressive enforcement practices to signal their competence to their prospective employers.” On the other hand, an SEC attorney might “under-emphasize or even compromise enforcement outcomes to curry favor with prospective employers.”

In order to test these theories, the authors tracked the records of 336 SEC lawyers who worked on SEC enforcement actions between 1990 and 2007. The academic study divided those lawyers into two groups: “revolvers,” who ended up leaving the agency to join a law firm, and “non-revolvers,” who went to work for another kind of firm or organization, or were still at the SEC by the end of 2010.

The authors also looked at four variables in the enforcement actions handled by the SEC lawyers: 1) the size of damages collected by the agency, 2) whether or not there were criminal charges brought in conjunction with the SEC’s action, 3) whether or not the agency named a CEO as a defendant, and 4) whether the SEC settled the charges or won a contested case.

Using this approach, the authors found “no significant differences in the enforcement outcomes” of revolvers and non-revolvers.

However, the results changed when the authors looked at revolvers who joined law firms that frequently defended clients in SEC enforcement cases—described in the study as “SEC specialist firms”—during the study period (1990 to 2007). The authors found that revolvers who joined SEC specialist firms tended to work on enforcement cases that resulted in “higher damages collected,” “a higher likelihood of criminal proceedings,” and “a higher likelihood of naming the CEO as a defendant.” (The revolvers were also more likely to settle than to win an enforcement case. But the authors noted that a vast majority of SEC cases are settled, potentially skewing the results, and they questioned whether “settling a case is a result of lax or aggressive enforcement.”)

Furthermore, the authors found “no evidence that SEC alumni in defense firms practicing before the SEC are able to exercise influence over ongoing enforcement efforts.”

According to the authors, these results show that “SEC regulatory efforts are not, on average, compromised as a result of lawyers leaving the Commission.” “If anything,” they wrote, “future job prospects make SEC lawyers increase their enforcement efforts while they are at the SEC.”

These findings should mollify concerns about the SEC revolving door, the authors argued. But POGO found that the academic study does not address a wide range of concerns.

No Mention of Regulations or Exemptions

First and fundamentally, the study does not examine the effects of the revolving door on one of the SEC’s basic functions: writing rules. It focuses solely on the enforcement of rules that are already on the books.

Did the revolving door contribute to the stalemate on money market fund regulation? Has it influenced the SEC’s long-running, overdue effort to write rules implementing the contentious Dodd-Frank Act? Has it affected the agency’s rulemaking—or lack thereof—in response to allegations that structural problems in the stock markets favor high-frequency traders such as hedge funds over ordinary investors?

The study also did not look at whether the revolving door influenced the way agency officials think about waivers, exemptions, and other forms of regulatory relief.

It would be difficult to address these questions in a purely statistical analysis. But if the revolving door influences the SEC’s work at all, there is no reason to think it would only influence SEC enforcement cases. The revolving door is also on display whenever an SEC employee writes a rule affecting an industry where she used to work, or when a former employee requests regulatory relief for a client after he leaves the agency.

A Narrow Look at SEC Enforcement

Robert Khuzami, former head of the SEC’s Enforcement Division

As for the SEC’s enforcement work, the former head of the SEC’s Enforcement Division, Robert Khuzami, cited the study as evidence that the revolving door does not make a difference in the SEC’s policing. “In the face of overwhelming proof to the contrary, and armed with nothing but cynical assumptions and speculation, commentators perpetuating this revolving door myth do a disservice to the hard-working and dedicated enforcement staff,” Khuzami wrote in an opinion piece for Reuters.[194]

But, even with respect to enforcement, the academics looked only at a subset of SEC lawyers and cases that could be affected by the revolving door.

Arbitrary Distinction Between Revolvers and Non-Revolvers

The academic study is premised on the idea that SEC enforcement lawyers can be divided into two categories: “revolvers” and “non-revolvers.”

But some lawyers who were counted as non-revolvers do not fit neatly into that category.

For instance, what if lawyers who were still at the SEC—and counted as non-revolvers in the academic study—just hadn’t gotten around to leaving yet? The authors told POGO they picked the end of 2010 as a cutoff to see if SEC lawyers were still at the agency (around 58 percent of the 336 lawyers in the authors’ dataset were still at the agency by then). All lawyers who were still at the SEC were counted as non-revolvers—even though some of them may have been influenced by the revolving door and ended up going through it sometime after 2010.

Until the moment they left the SEC, these employees would have been counted as non-revolvers, according to the model used in the academic study.

The authors’ way of dividing the SEC staff poses another question: Why should an SEC lawyer who took a job at a Wall Street investment firm or a publicly traded corporation be considered any less of a revolver than an SEC lawyer who took a job at a law firm that represents those businesses? If they both end up defending the same businesses from the SEC, what difference would it make if one became in-house counsel and the other became outside counsel?

Of the 336 lawyers covered in the academic study, 37 left the SEC for employers other than law firms. Further, the authors explained to POGO, these “other” employers included government agencies, academic institutions, and private-sector firms that have nothing to do with the SEC.

But some former SEC enforcement attorneys have gone to work in-house at firms that operate squarely within the agency’s jurisdiction. (See Appendix B) They, too, would have been counted as non-revolvers in the academic study.

The SEC alumnus in POGO’s database who filed the second most statements—a former assistant chief litigation counsel who represented the Enforcement Division in numerous SEC cases during the study period, according to federal court records—became an in-house lawyer at Bank of America. According to his disclosure statements, he represented Bank of America in several SEC enforcement matters. (See Appendix A)

To sum up, the study purports to compare two distinct populations—revolvers and non-revolvers. But this may largely be a distinction without a difference. If the study is comparing oranges to oranges, the fact that both yield orange juice should come as no surprise. As it turns out, revolvers and non-revolvers alike are often involved in weak enforcement outcomes. On average, in the enforcement cases involving both revolvers and non-revolvers that the academics reviewed, the SEC recovered 0.4 percent of the estimated loss to shareholders. In 30 percent of the cases, the SEC recouped no monetary damages at all, the study found.

High-Profile and Crisis-Related Cases Excluded

In addition to omitting some former SEC lawyers who did in fact go through the revolving door, the academic study leaves out several kinds of SEC enforcement cases.

The study relied on a database prepared by other academics—known as the Karpoff Lee Martin (KLM) database—that tracks cases in which the SEC and other agencies charge defendants with alleged accounting violations. POGO reviewed the KLM database and found that it does not include many of the big, systemic offenses allegedly perpetrated by Wall Street firms during the study period (1990 to 2007).

For instance, it does not include prominent cases in which the SEC charged financial firms with such offenses as exerting undue influence over investment research analysts, engaging in manipulative mutual fund trading, misleading investors about the safety of auction rate securities, and rigging bids for municipal bonds, because these cases did not include charges of accounting violations.

Furthermore, the academic study looked only at enforcement cases through 2007, based on an earlier version of the KLM database. So the study could not say whether the revolving door affected the SEC’s response to the 2008 financial crisis.

In other words, the study did not take us behind the headlines of the past few years to see how, if at all, the revolving door influenced some of the SEC’s high-profile enforcement efforts.

Informal and Non-Public Investigations Left Out

The study looked only at enforcement cases in which the SEC actually brought charges. But, as the authors acknowledged, the revolving door can come into play at other stages in an SEC probe.

Some law firms defend clients from the SEC during “informal investigations and inquiries that are not publicly disclosed,” the authors wrote.

Indeed, many alumni filed disclosure statements indicating they intended to represent clients during the informal or preliminary stages of an SEC probe. For instance, Andrew J. Dunbar—a former enforcement attorney in the SEC’s Los Angeles office who left the agency in August 2008—filedthreestatements from 2008 to 2009 saying he planned to represent clients that had received an “informal request for information” from the Los Angeles office.

The study did not look at this kind of informal inquiry, nor did it examine cases in which the SEC did not file any charges. It did not explore, for instance, the SEC’s probe into alleged accounting violations at Lehman Brothers, which in 2008 filed the largest bankruptcy in U.S. history. A court-appointed examiner reported in 2010 that Lehman had used an “accounting gimmick” (in the words of a former Lehman employee) to temporarily remove billions of dollars in assets from its balance sheet, but the SEC has not brought charges against Lehman, its former executives, or its former auditor, Ernst & Young. (A state regulator, the New York Attorney General, did bring charges against Ernst & Young for allegedly aiding a fraud at Lehman. Ernst & Young has said there is “no factual or legal basis” for the Attorney General’s charges.)

It would be difficult to study preliminary SEC inquiries and cases closed with no charges, because those matters are typically kept confidential. But if the revolving door has any influence on the outcome of SEC enforcement actions in which charges are filed, it could easily affect the other stages of an SEC probe.

Administrative Enforcement Cases Left Out

The academic study also leaves out cases the SEC chose to file in an administrative forum instead of a federal court. The agency can bring charges in either venue, but the study focuses only on cases brought before a court because “administrative cases do not have case dockets which identify the lawyers involved.”

Stavros Gadinis, an assistant professor at UC Berkeley Law School, has found that large firms often receive favorable treatment in SEC administrative cases. But the academic study could not explore whether revolvers were more or less likely to have worked on those cases.

No Analysis of Industry-to-SEC Revolving Door

The authors of the study acknowledged another major blind spot: Due to data limitations, they were unable to study “the reverse revolving door phenomenon,” which they define as “the impact of SEC hiring from industry on its enforcement efforts.” They noted, for example, that the “reverse revolving door” was on display when Robert Khuzami became the SEC’s enforcement chief after working as a general counsel at Deutsche Bank.

Were the SEC’s enforcement priorities influenced by the fact that Khuzami was formerly a senior Deutsche Bank executive? For example, was the SEC’s approach to cases related to the financial crisis influenced, however subtly, by the fact that he was part of the financial industry while the crisis built? The academic study could not answer such questions.

To be sure, an empirical analysis might uncover evidence that the industry-to-SEC revolving door actually helps investors. SEC officials, academic researchers, and industry representatives have argued that “[a]ttracting specialized market experts, as well as those with the expertise that SEC traditionally has sought (including lawyers, accountants, and compliance personnel) helps the agency fulfill its mission of investor protection,” according to the GAO’s 2011 report.

But there can also be conflicts of interest whenever an SEC official is in a position to oversee a former employer, client, or industry. The academic study did not explore whether those conflicts ever led to weaker regulatory outcomes. (See Appendix B)

Giving Revolvers Credit for Going After Small Fish

The academic study did find that SEC lawyers who ended up joining SEC specialist firms were more likely to have worked on cases in which a chief executive was charged.

But the cases in question did not generally involve the CEOs of powerhouse Wall Street firms. Rather, they involved the likes of James R. Powell, who headed Daisytek International Corporation, an Allen, Texas-based office product and computer supply distributor.

It’s possible that revolvers were picking easier targets in order to put more notches in their belts, and to avoid losing to more formidable legal adversaries—including, perhaps, SEC alumni who went on to represent big companies. (This might help explain the study’s finding that revolvers were more likely to have worked on enforcement actions against smaller firms.) Furthermore, suing the chief executive of a small firm would probably carry less career downside for an SEC lawyer than suing the chief executive of a too-big-to-fail financial institution.

In a January 2013 article, SEC enforcement officials touted the increase in SEC enforcement charges against individuals. Despite this trend, John C. Coffee, Jr.—a professor at Columbia Law School—wrote in January 2013 that SEC “actions against high-ranking senior executives of financial institutions remain conspicuous by their absence.” The SEC still has not charged a senior executive at “Lehman, Bear Stearns, AIG or the other major players in the 2008 financial collapse,” Coffee added.

The study found that revolvers who join SEC specialist firms were “more likely to settle rather than win” the cases they handled at the SEC.

The greater propensity to settle “could be interpreted as prima facie evidence of lenient enforcement,” the authors wrote, but they discounted that interpretation. Settling may have yielded stronger and more efficient outcomes for the SEC than taking the cases to trial, they pointed out.

Yet, some commentators have questioned whether SEC settlements are strong enough to deter future misconduct, especially if the agency does not simultaneously charge senior executives. In reviewing the SEC’s enforcement record, Coffee concluded that the agency is “settling cheaply with entities and ignoring individuals—a policy of ‘parking tickets’ for securities fraud.”

It’s clear that enforcement lawyers can make a name for themselves by being associated with high-profile cases. But it may matter less whether those cases achieve real justice or meaningful deterrence. Judging from the boasts SEC alumni make in their biographical profiles, it appears that big-dollar settlements can confer sufficient bragging rights.

Furthermore, many SEC settlements include a provision—controversial among the agency’s critics—that permits defendants to say they admit no wrongdoing. In December 2011, when Judge Jed Rakoff threw out a proposed settlement between the SEC and Citigroup, he wrote that a “judgment that does not involve any admissions and that results in only very modest penalties is…viewed, particularly in the business community, as a cost of doing business imposed by having to maintain a working relationship with a regulatory agency, rather than as any indication of where the real truth lies.”

An “allegation that is neither admitted nor denied is simply that, an allegation,” he added.

In other words, no-admit settlements—the favored tool of the SEC—could be an indication of compromised enforcement efforts at the agency. But the study’s authors dismiss this possibility in their analysis.

The academic study’s findings indicate that revolvers also tend to pull their punches when they are preparing to switch sides.

“Revolvers in their last year at the SEC: (i) collect significantly lower damages; (ii) have a lower probability of charging a CEO; and (iii) are associated with a lower likelihood of winning,” the study found.

One of the authors offered a benign explanation to POGO: some SEC lawyers may simply “slack off” during their last year at the agency, having already established their reputation as tough enforcers, he said. But another plausible explanation is that some lawyers are soft-pedaling cases during their final months at the agency because they think that’s the best way to curry favor with a potential employer.

Calculating the Incalculable

In his opinion piece for Reuters, even as he touted the academic study’s conclusions, Khuzami torpedoed its underlying logic, noting that individual SEC staff members do not determine the outcomes of cases.

“[T]he reality is that enforcement case recommendations are made by teams of attorneys, with multiple levels of review and scrutiny throughout the agency—all of which means that it is virtually impossible for any one person to make decisions on a case based on anything other than the facts, the evidence, and the law,” Khuzami wrote.

The authors acknowledged in the study that “a skeptic can question whether an SEC lawyer has significant discretion over the penalty structure imposed on the culpable firm.”

“However, if one were to argue that SEC lawyers have little or no influence over enforcement outcomes,” they wrote, “then the debate over revolving doors compromising regulatory efforts is moot.”

It is perfectly understandable that the authors chose to focus on individuals who go through the revolving door. In fact, individuals can make a big difference at the SEC. As described in Part I, the actions of an individual SEC Commissioner tipped the balance in derailing one of the top priorities of the previous SEC chairman.

By zooming in so closely on a narrow subset of SEC lawyers and cases, the authors may have missed the forest for the trees.

The real shortcoming of the study is its assumption that the revolving door and regulatory capture can be neatly quantified and measured. By zooming in so closely on a narrow subset of SEC lawyers and cases, the authors may have missed the forest for the trees.

If there is any evidence of regulatory capture at the SEC, it is likely to be found in the broader assumptions and norms that underlie the work of revolvers and non-revolvers alike.

For instance, employees throughout the SEC appear to take pride in no-admit settlements that serve the interests of accused companies. When the SEC entered into a no-admit settlement with Goldman Sachs in 2010, the agency celebrated it as the “largest-ever penalty paid by a Wall Street firm,” while Goldman Sachs described it as “the right outcome for our firm, our shareholders and our clients.” Although the SEC did bring charges against an individual Goldman Sachs employee, it did not go after any senior executives at the company. Paul Atkins, a former SEC Commissioner, remarked that the agency’s enforcement action was “basically playing for headlines with very little substance,” according to the New York Observer.

Khuzami has said that no-admit settlements “serve the critical enforcement goals of accountability, deterrence, investor protection, and compensation to harmed investors,” according to 2012 congressional testimony. In many cases, he argued, requiring defendants to admit wrongdoing “would likely result in longer delays before victims are compensated, dilution of the deterrent impact of sanctions imposed because of the passage of time, and the expenditure of significant SEC resources that could instead be spent stopping the next fraud.”

But when it comes to deterring wrongdoing or holding wrongdoers accountable, no-admit settlements may not do much to advance the public’s interest, especially if the SEC does not charge individual executives at powerhouse firms, as Judge Rakoff and other critics have pointed out.

A similarly accommodating outlook can be seen in the SEC’s willingness to provide waivers and other forms of regulatory relief to companies, including those accused of being repeat offenders, as described in Part II. If SEC officials considering these accommodations envision themselves sitting on the other side of the table one day, they could have a vested interest in seeing that the agency grants such requests.

In this sense, the revolving door may help shape the culture and ethos of employees throughout the SEC—and the institution’s prevailing way of doing business. This kind of influence is hard to measure, but it can still be beneficial to the companies and individuals regulated by the SEC.

Looking Beyond the Numbers

Some people who represent clients before the SEC seem to think that the experience of agency alumni makes a difference.

The law firm of Morgan, Lewis & Bockius LLP boasts on its website that “[m]ore than 30 lawyers at Morgan Lewis have worked at the SEC, including a former Chief Trial Counsel for the SEC’s Division of Enforcement and a former General Counsel to the SEC’s Chief Accountant.”

SEC experience can help alumni and their clients in a number of ways, former officials say.

David B.H. Martin, a former head of the SEC’s Corporation Finance Division, told POGO that SEC alumni “do have views about what types of arguments are likely to be effective.”

“The value you can bring to a client,” he said, “is understanding the arguments and language that resonate better with the SEC.” Although some of the most successful securities defense attorneys have never worked at the agency, he added, those with agency experience “may understand differently how your message will be received.”

Another former SEC staffer, Roger D. Blanc, told POGO there are “contexts in which having worked at the SEC can give you insight as to the thought process of the Commission and can help you understand where they’re coming from.”

Adam Pritchard, a former SEC senior counsel, said that “it’s a real advantage” for a company to hire an agency alumnus. “If I’m a client, I’m very pleased. I’m willing to pay top dollar for that,” he told Bloomberg.

Others say SEC alumni do not get any special treatment because the agency decides matters objectively.

Stephen Crimmins, a former SEC litigator, told POGO he gets “no special deal over there, and neither does anyone else.”

Some former officials presented arguments on both sides.

“It would be disingenuous to say that an alumnus, during his first years away from the Commission, when he knows various department heads, isn’t going to have some greater comfort level,” former SEC Chairman Arthur Levitt told POGO. “But I don’t think the substance of the relationship is significantly different than if he had not been a Commission alumnus. I’d say there’s a greater comfort level initially, but it doesn’t go beyond that.”

Alan L. Dye, who worked in the SEC’s Division of Corporation Finance and in the office of a former chairman, told POGO that his SEC experience has helped him in two respects: “One, I know some of the people over there…which I hope gives me some credibility when I have a matter before them. Two, having worked there, I probably have a somewhat better understanding of the processes at the agency than someone who didn’t work there.” But, Dye said, the SEC “staff would never take a position or provide a particular interpretation as a favor to someone, and I would never ask.”

“While their [SEC] service has undoubtedly made them more knowledgeable about the rules and regulations that govern the securities industry,” SEC spokesman John Nester told POGO, “we decide issues on their merits regardless of anyone’s background or experience.”

Firms that make self-serving claims about hiring SEC alumni may not have any noticeable advantage when they interact with the SEC. As POGO’s research shows, you don’t have to be a former SEC lawyer to win relief from the agency—a waiver, an exemption, or a no-action letter.

But that does not mean the revolving door is irrelevant to SEC decision-making.

The fact that so many SEC officials, including people at the top, came from industry and/or are on a path to industry, might help shape the environment in which all of them work.

Cultural Capture

Several academics have explored the idea that the revolving door can lead to the “cultural capture” of a regulatory agency.

Stavros Gadinis, an assistant professor at UC Berkeley Law School, has observed that regulators with industry origins can become “‘socialized’ toward that industry’s concerns and aspirations, carrying that perspective into their regulatory tasks.”

James Kwak, an associate professor at the University of Connecticut Law School, has written that financial regulators “are likely to share more social networks with financial institutions and their lawyers and lobbyists than with competing interest groups such as consumers.”

“The revolving door between government and industry, by creating social connections between people on opposite sides of the door, therefore has an influence even on people who are personally impervious to its attractions,” he wrote.

“[T]he problem may be this kind of excessive identification of the regulators with the companies they’re regulating.”

“[T]he problem may be this kind of excessive identification of the regulators with the companies they’re regulating,” Kwak told POGO.

Lawrence G. Baxter, a visiting professor at Duke University Law School, has argued that revolving doors can create “the unseemly appearance, if not reality, of an incestuous relationship between regulators and industry that must surely risk fostering an improper influence of industry over the regulators.”

Emails between SEC officials and former Commissioner Annette Nazareth, obtained by Bloomberg through FOIA, illustrate how agency alumni can at least help get a foot in the door.

Former SEC Commissioner Annette Nazareth

In one email exchange from November 2009, then-general counsel David Becker told Nazareth that he would connect her with Robert Cook—who had just been named as the head of the agency’s Trading and Markets Division, and was Becker’s former private-sector colleague—to discuss a draft of the Dodd-Frank bill. “I’m going to encourage Robert Cook to call you for the scoop,” he wrote.

At one point, Nazareth emailed Becker from the SEC lobby to request an unscheduled meeting. Becker responded five minutes later agreeing to meet.

When Nazareth sent Becker and the five SEC commissioners her law firm’s summary of the Dodd-Frank bill, Becker remarked that it “should go into extensive detail about the inanity of the Investor Advocate,” a new SEC office created under the bill.

Nazareth replied that she had asked the Securities Industry and Financial Markets Association, a securities industry lobbying group, to “trash” it.

These emails illustrate the cozy ties between Nazareth and her former agency, and show how the revolving door can blur the line between a regulator and the industry it oversees.

On any given day, SEC staffers are confronted with critical decisions about regulations and enforcement actions affecting the public’s interest. Even when an employee complies with government ethics rules and makes every effort to remain independent and neutral, his outlook can be shaped by his industry experience, his ongoing ties with industry representatives, or his plans to work for the industry after leaving the agency.

It’s hard to show on a case-by-case basis that the revolving door is a direct cause of weak SEC action, whether that be the agency’s response to the financial crisis or the terms on which the agency settles with law-breaking companies and executives. But if the revolving door affects the mindset of SEC regulators in any way, it may at least help to explain why the agency does not take a tougher stand against the businesses it oversees.

If nothing else, the cultural capture of an agency such as the SEC can undermine the public’s trust in our nation’s federal regulatory system. In a 2012 survey, only 39 percent of investors said they trusted government regulators to protect their interests. The revolving door engenders distrust in government by creating the perception, and possibly the reality, of a cozy relationship between government and industry.

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Founded in 1981, the Project On Government Oversight is a nonpartisan independent watchdog that champions good government reforms. POGO’s investigations into corruption, misconduct, and conflicts of interest achieve a more effective, accountable, open, and ethical federal government.